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Under The Hood: Take China, Leave The Banks

The already crowded field of ETFs offering exposure to China (approximately 230 funds) got a little more crowded today with the introduction of the WisdomTree China Dividend Ex-Financials Fund (NASDAQ: CHXF).

With there being no dearth of China ETF options from which investors can choose, new entrants to the arena must to do something to standout in order to poach assets from previously existing funds. As its name implies, the WisdomTree China Dividend Ex-Financials Fund does do something different and that is skimp on financial services stocks.

WisdomTree has found success with the ex-financials strategy in the past as the WisdomTree Dividend ex-Financials Fund (NYSE: DTN) and the WisdomTree International Dividend ex-Financials Fund (NYSE: DOO) have about almost $1.7 billion in combined assets under management.

The strategy, while new to a China ETF, is arguably overdue as some China-specific funds have been criticized for excessive weights to the financial services sector. For example, the iShares FTSE China 25 Index Fund (NYSE: FXI), the largest China ETF, allocates 52.3 percent of its weight to financials. The SPDR S&P China ETF devotes almost 32 percent of its weight to the sector.

"The case for investing in China has become increasingly apparent to investors, but we believe some of the most popular China index-bases strategies fail to offer diversified exposure," WisdomTree Chief Invest Strategist Luciano Siracusano in a statement. "We think investors should be able to access the growth potential of China without taking such concentration risk."

CHXF's largest sector weight is energy at almost 24.6 percent and China's three largest oil companies – PetroChina (NYSE: PTR), Sinopec (NYSE: SNP) and Cnooc (NYSE: CEO) – are found among the ETF's top five holdings. Materials and telecommunications names each account for more than 14 percent of the new ETF's weight while industrials and consumer staples each garner allocations north of 13 percent.

Yield information is not yet available for the ETF, but the index has a dividend yield of almost three percent, according to WisdomTree data.

Some investors may wonder if skirting Chinese financials does payoff. At the very least, it does help lower a portfolio's volatility.

"An equal-weighted blend of the non-financial sector indexes in China, “China ex-Financials,” had an average annual standard deviation of about 2 percentage points less than the MSCI China Index and 10 percentage points less than the MSCI China Financials Sector Index over the 10 years from June 30, 2002, through June 30, 2012," according to a note written by WisdomTree Research Director Jeremy Schwartz.

Importantly, reducing exposure to Chinese financials has lead to better returns this year. The Guggenheim China Small-Cap ETF (NYSE: HAO) and GXC have both outperformed FXI with lower weights to financials.

"China is one of the more important economic actors on the global stage, and as such its investment markets are expected to continue attracting significant attention," Schwartz wrote. "Anytime this occurs, it is important to take a step back, especially when considering the
performance of equity market indexes. How constituents are selected and then weighted has a major influence on the performance that these indexes measure. Given that we imagine many investors may not want to take a sector bet resulting in 50% exposure in China's equities weighted directly in the financial sector, we think it makes sense to consider an alternative way of building an index for China's equities."